Ecb impact on italian spreads

Italy's spreading problems

The end of the ECB's quantitative easing programme will put Italian government bonds under more pressure.

Italy’s latest spat with Brussels has been generating headlines. But if crisis strikes, it’s likely to come from a different direction: Frankfurt. That’s because Italy has a debt flow problem. For all the friction the country’s new populist coalition is generating with the European Commission over Italy’s proposed budget, the ultimate source of near-term market tension is the European Central Bank.

That's because Italy has been a major beneficiary of the ECB’s quantitative easing programme. Since the start of QE, the central bank’s purchases of Italian debt have outstripped the volume of new government bonds the country has issued. But as the emergency programme comes to an end, that trend will go into reverse.

Italy’s current budget imbroglio brings forward a problem that would have arisen in the coming months anyway: without ECB buying, Italian yields have to rise in order to draw in private sector funding.

In October, the ECB cut the amount of bonds it was buying under QE to EUR15 billion a month from EUR30 billion – itself a halving of the rate at which it was buying bonds in 2017 – ahead of ending it altogether before the New Year. Then, for the first time in years, price-sensitive private buyers will determine where Italian government bonds trade and, ultimately, whether country's EUR2.3 trillion debt pile - the third largest in the developed world - is sustainable.

By the start of November, the ECB held EUR362 billion of Italian government debt, some 17 per cent the ECB’s total holdings of government bonds. As the ECB has bought less debt, Italian yields have been rising. The spread on Italian 10-year bond yields over equivalent German bunds has recently risen above 300 basis points, up from an average of 141 basis points when the ECB had its foot fully on the monetary pedal.

Current projections suggest that on a net basis, and factoring in ECB purchases, the private sector will have to absorb EUR57 billion of Italian government bonds next year. This compares with EUR11 billion in 2018 and a negative EUR54 billion in 2017 (ie there were net sales by the private sector in that year).

The question is what that means for spreads. Even if conditions calm down, spreads are unlikely to return to their averages of the past few years. As a best guess, the new range for Italian debt is somewhere between 250 to 350 basis points – the top of the range representing the level at which bank deposits flooded out of peripheral country banks during the euro zone crisis of 2010-2012. At the same time, our economists estimate that once Italian sovereign yields rise above 4 per cent, the debt becomes unsustainable, other things being equal.

As for now, concerns about Italy’s relations with its European partners mean that financial markets are starting to price in the risk the country drops out of the euro, which will contribute to the wider spread. Currently, our estimates suggest investors are demanding 200 basis points for credit risk and 100 basis points for the possibility Italy will be forced to re-denominate – we estimate that the market is pricing in a 7 per cent probability that Italy will be forced out of the euro over the next couple of years.

Steve Donzé joined Pictet Asset Management in 2007. He is a Senior Macro Strategist in the Swiss Multi Asset team. He co-manages a range of multi asset flexible strategies.
A member of Pictet Asset Management Strategy Unit, he engages in public debate on monetary policy-making.
Prior to Pictet, he held positions at the Swiss Bankers Association and the Swiss Ministry of Foreign Affairs.
Steve holds a Master’s degree from the Graduate Institute of International and Development Studies and a PhD from the London School of Economics.

About

Andrea Delitala

About

Andrea Delitala

Andrea Delitala joined Pictet in 2007 and is Head of Investment Advisory in Milan. Before joining Pictet, he was Partner, Strategist and Money Manager (Total Return) at Novagest SIM. Between 1997 and 2004 he was Global Head of Economic and Fixed Income Research at investment bank Sanpaolo IMI. From 1992 to 1997 he was a Senior Economist at Deutsche Bank in London. Previously, he spent four years as a Junior Analyst in the Corporate Finance Department, at Republic New York Finanziaria in Milan (a subsidiary of Republic National Bank of New York). He started his career in 1985 as a Financial and Tax Consultant at Studio Legale Delitala (law firm). Andrea holds a degree in Economics and Social Disciplines (five-year programme) from the Bocconi University in Milan, focusing on Mathematical Analysis, Macroeconomic Statistics and Econometrics.

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